1. is equal to the ratio of the two countries' price levels.
2. measures the price of the country's output in terms of the output of the other country.
3. measures the real wage rate in the country relative to the real wage rate in the other country.
4. measures the value of the country's currency in the currency of the other country.
Choose the correct option.
Option 2 is the correct one. Since the real exchange rate is defined as
Q = P / Π P*
and Π P* is the foreign price level measured in the domestic currency, Q is equal to the ratio of the domestic price level in domestic currency to the foreign price level in domestic currency. This is the price of domestic output in terms of foreign output. Options 1 and 4 are incorrect because they do not measure the price levels (or values of the two moneys) in the same currency. Since the real exchange rate is dependent on all of the inputs in production in the two countries, not just labour, it need not be equal to the ratio of the domestic to foreign value marginal products of either labour or any particular non-labour input.